Given macro headwinds, many investors are naturally worried about grocery stocks. I find that a poor outlook has overly depressed some stocks, while sparing others. Safeway (SWY) and Kroger (KR) are two retailers that fall in the former camp. Although the Street rates shares of Safeway closer to a "sell" than a "buy", I find that aggressive buybacks and store count decline will maximize shareholder value beyond expectations. Kroger, meanwhile, has shown strong execution and promotional activity.
From a multiples perspective, Kroger is the cheaper of the two firms. It trades at a respective 12.2x and 10.7x past and forward earnings while offering a dividend yield of 1.9%. Safeway, on the other hand, trades at a respective 13.9x and 11.2x past and forward earnings while offering a dividend yield of 2.8%. While promotions have locked in a strong market share for Kroger, I am concerned about the retailer's gross margins of 22.2%. Supermarket sales for the industry as a whole decelerated to around 2% in November, indicating slower-than-anticipated demand growth.
At the third quarter earnings call, Safeway's CEO, Steve Burd, noted:
"Net income for the quarter was just over $130 million. This compares with net income from the same quarter a year ago of just under $123 million. Expressed in terms of earnings per share, we made $0.38 this quarter. A year ago, we made $0.33 a share, representing a 15% increase in earnings per share.
By way of some quick highlights, our earnings per share results were above first consensus estimates and above our own internal expectations. ID sales were much stronger than they were in quarter 2, and they strengthened as we moved throughout the quarter. Our gross margin rate, adjusted by both fuel sales and the Blackhawk reporting change that we announced last quarter, was flat with last year despite all the challenges of keeping up with inflation. And then O&A expenses as a percentage of sales were less than last year. As a result, operating margin expanded moderately, just as it did in quarter 1".
Management increased its share repurchase program to a stunning $1.9B, up from $1B previously. I am anticipating that slightly more than 40% of this will be paid out sometime in 2012. The firm will receive a nice cash injection of around $100M from selling off Burnaby and improving efficiency. The firm is closing down stores and remaining rightfully committed to increasing sales per square foot. This overall streamlining will position the company well when the economy fully recovers.
Consensus estimates for Safeway's EPS are that it will grow by 11% to $1.72 and then by 7.6% in both of the following two years. Assuming a multiple of 15.5x and a conservative 2012 EPS of $1.75, the stock has 31.9%. I believe that the multiple will expand due to growth exceeding expectations and outperforming inflated peers. Even if the multiple were to decline to 12.5x and 2012 EPS turns out to be 8.1% below the consensus at $1.70, the stock is fairly valued.
Kroger similarly has favorable risk/reward, but is actually rated a "buy" on the Street. Third quarter results beat the consensus with earnings per share of $0.33 - a y-o-y improvement. Similar to Safeway, Kroger showed a commitment to returning free cash flow to shareholders by repurchasing $1.2B worth of shares. Investors are nevertheless unreasonably disappointed by managements commitment to gaining share versus accelerating top-line growth. Due to structural and economic factors outside of their control, however, gaining share is the appropriate strategy, in my view. If the company increases penetration, its multiple could expand to 15.5x and with a conservative 2013 EPS of $2.18, the stock would appreciate by 42.5%.
Consensus estimates for Kroger's EPS are that it will grow by 13.6% to $2 in 2012 and then by 10.5% and 7.7% in the following two years. While I believe that both companies are undervalued, I see greater safety with Kroger due to its brand diversification and attractive gasoline rewards program.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.